Shoreline Wealth and Investment Mangement  

Sign up and receive
the free report
’27 Tips for Choosing
a Financial Advisor’

Business Transfer

Transfer of Closely Held Businesses
If you are an owner of a closely held business, the thought of estate taxes no doubt is an alarming one. If not, it should be.

Federal and state estate and gift taxes, imposed at top marginal rates of 45 percent, together with the generation-skipping transfer tax (GSTT) on transfers to persons two or more generations younger at a flat rate of 45 percent, combined with income taxes imposed over the years, can reduce the value of the business that a family can retain through the generations to an amount as low as 12 percent of the initial value. Thus, without proper planning, the work of a lifetime in growing the assets of your business can be decimated in one or two generations.

While estate tax reform is an item on the national agenda, as of this writing, the nature of estate tax relief is uncertain, so planning to preserve the value of your business and to transfer assets while minimizing these taxes is prudent. Estate tax policy to tax wealth at each generation (treating spouses as a single unit), avoiding the buildup of fortunes in families, and to encourage charitable giving, raises doubts as to the likelihood of the elimination of transfer taxes altogether.

What are your goals as the owner of a closely held business? No doubt one goal is to maintain the hard-earned value of your enterprise. Another may be to provide for the orderly transfer of this value to younger generations, while minimizing transfer (and income) taxes. The form of entity that you select is essential in order to obtain optimal valuations and tax savings and to ensure good long-term management.

Estate Tax Overview
A review of estate planning rules provides the basis for understanding the techniques discussed herein. Gift taxes, imposed on transfers during life, and estate taxes, imposed on the value of assets owned at death, apply at "unified" marginal rates, starting at 39 percent for cumulative lifetime and estate transfers in excess of the amount exempt from tax by reason of the "unified credit" (currently $1 million) and rising to a marginal rate of 45 percent for transfers in excess of $3 million. Each person should use this credit (and not waste it by giving all of his assets to his spouse) by, for example, transferring the "credit shelter amount" to a trust for the benefit of his spouse and descendants during his life or at death.

Despite the unified rates, the gift tax is more efficient, since it is "tax exclusive," imposed only on the net amount transferred (assuming the transferor lives for at least three years after making the gift), whereas the estate tax is imposed on all assets owned at death, including the tax dollars.
Questions EVERY Diversified Investment Advisors should ask you...
SWIMLLC vs. Warren Buffet... who performs better?

Consider John Doe, who owns a business worth $10 million. Jim is good at running his business but afraid to transfer too much control to his son (who comanages the business) during life. At Jim's death, the estate tax on his $10 million business (which he bequeaths to James Jr.) is $5.3 million, leaving $ 4.7 million for John Jr. The tax of $5.3 million has an effective rate of 115 percent of the net value which James Jr. receives.

If John Doe had been very smart, he would have used proper estate planning techniques to retain a satisfactory degree of control but give the same net amount of $4.7 million to James Jr. during life for a gift tax of $2.3 million, an effective rate of only 45 percent.

Also, the post-gift appreciation on the assets transferred during life will escape transfer taxes in John's generation altogether. Put another way, the early use of the unified credit is more valuable than its use many years later at death, because of the time value of money.

Lifetime transfers also can optimize management arrangements, permit leveraging and take advantage of potential discounts for transfer-tax purposes. However, property received by gift will have a "carryover" basis, as opposed to property received from a decedent which will have a basis "stepped up" to fair market value as of death. Nevertheless, at current rates, minimizing transfer tax at its marginal rate of 45 percent outweighs the potential cost of capital gains taxes. Proper planning should take also advantage of the right to transfer $1.03 million (slated to increase annually for inflation) to persons who would otherwise be "skip persons" without attracting the GSTT.

Transfer Taxes
To minimize transfer taxes, do not overlook your right to transfer $13,000 each year to any donee: a married father with four married children and six grandchildren can make "annual exclusion" gifts in a total amount of $260,000 each year.

Consistent with the policy to tax each generation, qualifying transfers between husband and wife are exempt, deferring the tax until the death of the survivor. The transfer must be outright or in a "qualified terminable interest property" (QTIP) trust, requiring current distribution of income to the spouse and permitting principal distributions at the discretion of the trustee, ensuring that assets remaining upon the surviving spouse's death will pass to the transferor's beneficiaries and not to outsiders. (If the surviving spouse is not a U.S. citizen, special rules apply, requiring a "qualified domestic trust" to obtain the marital deduction.) Combining transfers to family members with transfers for charitable organizations can provide tax relief and leveraging opportunities.

Choice of Entity
Your choice of entity will affect valuation of interests gifted to members of a younger generation, for example, by supporting discounts. To insulate against the IRS seeking to reduce a discount by looking through the corporate form to the underlying assets, the entity should limit the power of the owners to force dissolution or liquidation.

A Subchapter C corporation has the impediment of double tax on dividend distributions and liquidations. Also, some state statues offer protection for minority shareholders which could limit discounting opportunities. However, recent court decisions have supported a discount for built-in capital gains tax when valuing C corporation assets.

Subchapter S corporations avoid the double tax on dividend distributions and liquidations, but may be subject to a potential tax on liquidation, a built-in gains tax if previously a C corporation, and minority shareholder protection statutes. Only certain forms of trusts are permitted S shareholders: the "qualified subchapter S trust" (QSST) and the "electing small business trust" (ESBT). Since opportunities for traditional "estate freeze" techniques, such as the preferred stock recapitalization, have been severely restricted pursuant to Chapter 14, an S corporation may be attractive as it may have voting and nonvoting stock without violating its one class of stock requirement.

Nonvoting stock may be transferred to a QSST or ESBT for younger beneficiaries, taking advantage of valuation discounts, shifting current income, and removing value and appreciation from the estate, without jeopardizing control. Corporate formalities must be observed and valuation and management techniques must compare to an arms-length transaction. See, Speca v. Com'r, T.C. Memo 1979-120, aff'd. 630 F.2d 554 (7th Cir. 1980). Cf. Kirkpatrick v. Com'r, T.C. Memo 1977-282.

A general partnership avoids the double tax imposed on C corporations, but democracy of management and the power of the general partner to force liquidation or dissolution can limit valuation discounts. Also, the transfer of a general partnership interest may be costly for transfer tax purposes. Limited partnerships and limited liability companies (permitted by most state statutes) are important planning tools.

Taxable like a partnership (easily elected under the "check-the-box" rules), an LLC also enjoys limited liability. The Operating Agreement can:

1. provide guidelines for ownership, management and transfer of LLC interests, for example, granting a right of first refusal to, or requiring a vote by, the members of the LLC on transfer of an interest or sale of LLC assets;

2. restrict transfers to descendants of the original owner (or to a trust for a spouse of a descendant), maintaining family control; and

3. restrict withdrawals and limit the sales price of an interest in the LLC.
Some state LLC statutes contain similar restrictions and can prevent dissolution in the event of death or gift. These restrictions support valuation discounts. An election may be made to adjust both the "outside" and "inside" basis of the LLC assets held at death to reflect fair market value. Notably, the owner of a closely held business can transfer interests in the LLC to younger beneficiaries (for transfer tax purposes), but maintain control by requiring a unanimous vote by the original business owner(s) for certain transactions. This is an exception from the general estate planning rule that in order to remove assets from the owner's estate for tax purposes, control cannot be maintained over the assets transferred.
Valuation Considerations
Valuation rules are key in tax planning. The "fair market value" of a business interest is the price at which the interest would change hands between a willing buyer and a willing seller, neither party being under compulsion and both having reasonable knowledge of relevant facts. Treas. Reg. @ 20.2031-1(b). Rev. Rul. 59-60, 1959 CB 237. Relevant criteria include the nature, history and outlook of the business and its industry; the book value of the shares; the company's earning and dividend paying capacity; the existence of goodwill; prior sales of the company's shares; the size of the block of shares to be valued; and the market price of shares of publicly traded companies engaged in a similar business.

In the case of a closely held business, a valuation discount may be obtained as follows:
a. a minority interest discount, reflecting lack of control over decisions such as the election of directors or officers, salary levels, the timing and amount of distributions and whether to compel liquidation;

b. lack of marketability discount, reflecting the lack of a ready market for closely held shares (including a controlling block, because of the absence of a private placement market and the potential costs of a public stock offering). See, Estate of Andrews, 79 T.C. 938 (1982);

c. a fractional interest discount, reflecting ownership of less than an entire interest and that no single owner has total management control;

d. key person discount, reflecting the possible loss of a key person;

e. built-in capital gains discount - reflecting the tax on inherent capital gains. See, Estate of Babe v. Com'r, 110 T.C. 530 (1998); Eisenberg v. Com'r, 155 F. 3b 50(2d Cir. 1998);

f. blockage discount, reflecting the potential loss of value when trading a large block of stock (a discount which may be available for publicly traded as well as closely held shares); and

g. investment company discount, reflecting diversification and timing risks. Although in the past the IRS has argued that a family would act in concert, it has now agreed that minority interests transferred to family members should not be aggregated for purposes of evaluating discounts for lack of control. See, Estate of Bright v. Com'r, 658 F. 2d. 999 (5th Cir. 1981); Rev. Rul. 93-12, 1993-1 CB 202.
A range of percentages may be achieved for discounts. Specially qualified appraisers of discounts sometimes compute the discount by combining (or multiplying) the relevant factors. In Lauder v. Com'r, 68 T.C.M. 985 (1994), the Tax Court allowed a 40 percent discount for lack of marketability; it allowed a 35 percent discount for lack of marketability in Jung v. Com'r, 101 T.C. 412 (1993), and permitted a 36 percent discount in Gallo v. Com'r, 50 T.C.M. 470 (1985). Recently, the IRS has indicated that a 25 percent discount will not be challenged when claimed in an appropriate context. On the other hand, the IRS may counter a claim for a discount by seeking to tax a premium for control. See, Murphy v. Com'r, 60 T.C.M. 645 (1990).

However, even a control premium can be turned to the advantage of an owner, who could bequeath 51 percent of the business to his spouse tax-free and 49 percent to a trust for the benefit of his children, claiming a majority interest discount. If the surviving spouse subsequently gifts at least 2 percent of her interest to the children's trust, her estate can claim a minority interest discount and avoid a control premium. See, Chenoweth v. Com'r, 88 T.C. 1577 (1987). This is better than a bequest to the spouse, merely deferring tax until her death. A series of gifts, each entitled to a fractional interest discount, can be effective, provided that transfers from a deathbed will be ignored. See, TAM 9723009 and 9725002.

Buy, Sell Agreements
A buy and sell agreement can provide liquidity to the family of a deceased business owner and ensure continued control by the surviving managers. Buy and sell agreements should be carefully established and funded (for example, with life insurance) while the key persons are alive and well. A buy and sell agreement can avoid a transfer to an undesired third party (protecting S election or professional corporation status).

Forms of buy and sell agreements include a redemption or repurchase agreement - made between the owner and the entity; a cross-purchase agreement - made by and among the owners; or a hybrid agreement - where the entity is obligated (or has an option) to purchase the ownership interest of the deceased or withdrawing partner, but can assign its purchase right to the remaining owners.

Life Insurance
Life insurance is valuable in estate planning as, in general, the proceeds and growth in the invested assets are exempt from income tax. This may be more effective than investing in an IRA, which can convert capital gain to ordinary income, taxable upon withdrawal from the plan.

Life insurance also compares favorably to investing outside any plan, subject to current income tax. New forms of insurance afford greater investment discretion to policy owners. Also, opportunities exist with insurance for "leveraging" the transfer of value to a trust, which is the policy owner and beneficiary, for example, for the benefit of the insured's spouse and descendants. This is especially true with "split-dollar" life insurance, where the entity advances premiums on behalf of an employee, transferring value to an insurance trust. In transactions involving life insurance, care must be taken to avoid the "transfer for value" rule, subjecting insurance proceeds to income taxation if the policy is transferred for valuable consideration.

Private Annuity
With a "private annuity" a business owner may transfer ownership to his family members in exchange for their unsecured promise to make payments to him for life. Properly structured, no gift tax will be payable (if the present value of the payments stream equals the value of the transferred property); capital gains tax will be minimized; and the value of the annuity will be excluded from the transferor's estate.

The annual payments cannot be funded directly from the transferred property or the property may be included in the transferor's estate. Each annuity payment will be partially a return of capital (recovery of basis), partially capital gain and partially ordinary income (the interest portion of the annuity payment). The basis of the transferee in the transferred property will equal the present value of the annuity, with each payment increasing his basis in the property. See, Rev. Rul. 55-119, 1955-1 CB 353.

Defective Grantor Trusts
With a "defective grantor trust," an owner can transfer his business interest to a trust (for the benefit of his spouse and descendants) with provisions causing him to be taxable on the trust's income (as opposed to the general rule subjecting the trust to tax on its income).

This payment of tax by the grantor represents a gift tax-free transfer to his beneficiaries. Combining this with valuation discounts can make this straightforward transaction attractive.

The use of trusts can be combined with entity selection for ownership and transfer tax purposes. For example, interests in an LLC can be transferred to a trust for the benefit of the owner's descendants, providing a valuable shield from claims of the beneficiary's (1) unforeseen creditors, (2) a spouse at death (insulating against spouse's "right of election") and (3) a spouse in divorce. With a "grantor retained annuity trust" (GRAT), a family business owner can transfer the economic value of a business and future appreciation in the business for reduced transfer taxes, while retaining the right to a stream of payments from the business and a measure of control over management (gift tax being imposed only on the value of the remainder interest, after taking into account the value of the annuity).

Installment Sale
An LLC owner can transfer his interest to a defective grantor trust for an installment note, bearing minimum required interest, discounted to reflect applicable restrictions. Since transactions between a grantor trust and its owner are ignored for income tax purposes, the transferor may avoid capital gains tax on the sale of his LLC interest to the trust. (The death of the transferor during the term of the note may attract capital gains tax.) This can transfer future appreciation for low transfer tax, remove the asset from the transferor's estate, minimize capital gains tax and benefit from the low interest rates prescribed for loans (as compared to the rate which applies for a GRAT). Also, better GSTT opportunities exist for an installment sale than for a GRAT.

Family-Owned Business
The qualified family-owned business estate tax deduction (QFOBI) is computed in conjunction with the unified credit for a maximum aggregate amount of $675,000.

To qualify, the "qualified family-owned business interest" must comprise at least 50 percent of the adjusted gross estate, the business interest must either be a sole proprietorship or an interest in an entity in which the decedent and his family hold a certain percentage interest, and the decedent or members of his family must have "materially participated" in the operation of the business for a period aggregating five years or more during the eight-year period before the decedent's death and certain conditions must exist after death to avoid recapture.

Charitable Organizations
A transfer of a business interest can be combined with a deduction for a transfer to a charitable organization. For example, an owner could donate closely held stock to a charity for a charitable deduction, after which the charity could redeem the stock. Tax on capital gains would be avoided by the exempt charity and the redemption by the charity may constitute an indirect transfer of assets to the younger generation (if they hold an interest in the business prior to the charitable transfer), provided no prearranged obligation to redeem the shares existed.

Alternatively, corporate stock could be contributed to a charitable remainder trust, which could then redeem the stock. The proceeds of redemption could be reinvested in higher yielding, more diversified assets, while reducing income tax on the redemption, providing the transferor with annual distributions from the trust and an income tax deduction for the actuarial value of the charity's remainder interest. At the death of the transferor, the portion of the trust property includable in his estate will be offset by a corresponding estate tax deduction for the charity's interest.

An ESOP is a qualified employee benefit plan designed to invest primarily in stock of the sponsoring employer.

An ESOP can create a market for privately held shares and provide shareholders with access to the value of their shares on a tax-deferred basis without the loss of control. ESOPs can be effective in providing liquidity to pay estate taxes; deferral or avoidance of tax on income as it is recognized; the conversion of ordinary income to capital gain; and the facilitation of private business ownership succession.

ESOPs can provide an attractive alternative to the sale of the business if younger executives have been adequately trained as managers. Control can be retained by the family by selling a minority interest to the ESOP, or if the ESOP holds a majority interest by selecting the trustee with the right to vote the stock or by subjecting the trustee to direction from a committee selected by the Board of Directors.

The ESOP has certain potential disadvantages. Participants will share in the future growth of the business on a pro-rata basis. However, the "cost" of sharing equity with employees may be offset by increases in employee productivity, reductions in other employee benefits and tax savings to the corporation. Note that if the stock of an employer that sponsors an ESOP is not publicly traded, the participants have the right to require the sponsoring employer (not the ESOP) to repurchase any shares distributed to them. Before establishing an ESOP, the company should consider whether this put option might impose an undue financial burden on the company.

If a taxpayer elects to defer recognition of gain in connection with the sale of stock to an ESOP, the taxpayer will take a carryover basis in the qualified replacement property. Opportunities exist for investing the ESOP sales proceeds since the longer the replacement properties are held, the longer the tax on the gain realized on the ESOP transaction can be deferred. Capital gains tax can be avoided altogether if the replacement properties are held until the death of the taxpayer, due to the step-up in basis of assets held at death. Also, company stock can be gifted to a limited partnership or a charitable trust which can then sell stock to an ESOP.

A Business Alternative
An alternative that minimizes transfer taxes is the establishment of a "competing" company, owned and controlled by the younger generation, that gradually receives almost the entire business of the original corporation, as the management of the corporation retires and the allegiance of the customers is transferred.

Numerous estate planning techniques exist, ranging from simple to complex, to reduce transfer tax on a closely held company. Proper planning is essential to avoid the potentially confiscatory effects of these taxes on the value of your company.

(1) All references herein to Chapters, Subchapters or sections are to the Internal Revenue Code of 1986, as amended, unless otherwise stated.

Shoreline's Competitive Edge
Whatever your estate planning need, Shoreline Wealth and Investment Management can assist you in obtaining the best in tax planning advice.

For more information:
If you'd like more information about how diversified investment advisors can help you achieve your financial objectives through personalized wealth or retirement and risk management strategies, please contact us. We welcome the opportunity to discuss your unique needs and how we may best meet them.

This page (formatted for versions 10.0 and higher of Internet Explorer) is updated regularly so check in from time-to-time to see new articles and updates. You can click on any underlined words on each page to see a specific wealth management topic in the left margin of each page.

Charles M. Bloom, Registered Principal offers securities and advisory services through Centaurus Financial, Inc. - Member FINRA and SIPC - 775 Avenida Pequena, CA, 93111 (mailing address: 3905 State Street Suite 7173, Santa Barbara, CA, 93105) - CA Life Insurance License No. 0A52786 - Centaurus Financial, Inc. and Shoreline Wealth & Investment Management are not affiliated companies.

The information contained in this web site is neither an offer nor solicitation of any security or service.


Shoreline's Home Page
Return to home page


"Excellent. We were proud to have you speak before our group"

- California Society of CPA’s

Sign up and receive
the free report
’27 Tips for Choosing
a Financial Advisor’
  Shoreline Wealth and Investment Management - Phone: 805.886.3624 - E-Mail: